Debt vs. Equity – The Financing of Patent Monetization

Harvey Sener (left) and Eran Zur (right)

On November 6, 2014, at the IP Dealmakers Forum there was a particularly interesting and entertaining discussion about financing patent owners. The discussion was, in my opinion, one of the most insightful and informative presentations over the two day event. That is typically what happens when you have intelligent, thoughtful individuals with strongly held but divergent viewpoints. Indeed, the discussion highlighted two distinct strategies for making money providing financing to patent owners who are seeking to monetize their patents. The panel discussion was largely dominated by Eran Zur, Head of IP Finance of Fortress Investment Group, and Ashley Keller, Managing Director of Gerchen Keller Capital. Zur and Fortress lend money to patent owners who pledge a portfolio, or subset of a portfolio, as collateral to secure the loan. On the other hand, Keller and GKC finance patent litigation, employing an equity model.

The panel kicked off in a spirited way when the moderator, Harvey Sener, who is a Partner with Sichenzia Ross Friedman Ference, asked the panelists whether they would lend to or finance non-practicing entities or others who might be from a class of actors that has been vilified in the public — or in other words “patent trolls.” Zur explained that he and Fortress do not label potential borrowers, instead choosing to keep their eye on the assets and employing good, old fashion best lending practices. . “We focus myopically on the value of the patent — we are agnostic,” Zur explained. “If we think the assets are good enough to provide a loan based on the asset as collateral we will loan the money.”

As a debt provider they focus on the value of the patents and not what the borrower may want to do with the money obtained. On the other end of the spectrum Keller explained that he does care about whether they are financing a patent troll or non-practicing entity because who you are financing needs to be taken into account because financing is all about risk — when you finance a patent troll the litigation risk is much higher for a variety of reasons.

Sitting in the audience I couldn’t help but think that many in attendance, including those on the panel, were not following what Zur was trying to explain, which seemed obviously clear to me. Whenever money providers are involved risk needs to be taken into account, but if you are going to rely on collateral to secure a loan there are fewer things for the money provider to worry about. First, you have to worry about whether you have properly valued the assets in question in case the borrower defaults so that you can at least get back the money lent. Second, you have to consider whether the borrower has the means, and perhaps character, to repay the loan and not default. Through proper diligence, accurate valuation and lending to those who are likely to repay you can achieve two to three times the investment.

A debt providers does not want to seize the assets. The debt provider wants the loan repaid with interest. Through proper valuation and sound lending practices (i.e., lending to those who can and will repay) there is very nice return on investment with risk that is quite low. The model works from Fortress’ perspective because of the low risk and nice multiple, and it also works from the borrowers perspective because the money they obtain is far cheaper than working with a firm that would represent the patent owner on a contingency basis because those firms frequently look for 45% or more plus costs. The money is also far cheaper than a litigation financing company because those companies are looking for 10x, 20x or more return on investment, which comes with great risk so the money costs more.

Of course, this is not to question the business model of Keller or others similarly situated, but Fortress is taking a different path, employing a different philosophy. “Unlike with an equity model, when a debt provider looks at the asset there is a different analysis,” Zur explained. “The companies that we look at most of the time are companies that cannot get equity investment.” This is fine for Zur because the model he and Fortress are pursuing doesn’t look for or require equity level returns, which inherently come with far more risk.

“Our main focus is this one asset class, the patent asset class, which most financial institutions don’t give a value to,” Zur explained. “Are there patents here that can be an asset? We are a straight forward asset backed lender, looking at patents that are not litigated.” The fact that Zur is looking at assets that are not litigated is one of the major differences between what Fortress does and the equity model. To illustrate his point Zur gave an example of a company that has 100 patents and plans to sue on 5. “I want to see your other assets that you are not putting at risk,” Zur explained. The debt model works by valuing those assets not at risk in the litigation and, therefore, the value of those assets are not impacted by negative outcomes in any litigation pursued.

When Zur explained that he doesn’t want to look at the patents you are going to sue on, but patents that will not be litigated, Keller asked: “If there are 95 patents out of 100 they are not litigating how are you going to monetize those?” Keller would go on to say that he just doesn’t think you can accurately value patents as an asset because the law is evolving so rapidly. “There is inherent uncertainty,” Keller explained.

Keller’s point is well taken on at least several levels. The law as it applies to software patents and certain biotech related categories of invention have changed dramatically over the last several years. There is also no doubt that the changes have not be in favor of the patent owner. The net effect is that at least some, perhaps many, of the patents that cover innovations is the software and genetic space are worth less if not completely worthless. I don’t think it is an exaggeration to say that at least tens of thousands of patents, perhaps many more, now have claims that are almost certainly invalid thanks to either the law of nature doctrine or the abstract idea doctrine.

“The notion that bingo is abstract makes no sense to me,” Keller explained. “It has a lot of rules associated with it… so until the 101 landscape changes we are quite leery of claims years ago we would have been interested in. 101 is toxic.” This lead to one of the few agreements between Keller and Zur. “I agree. Many people are moving toward medical devices and bio-pharma, following the path of least resistance,” Zur explained. “Alice and all the decisions that devalued software patents might be overruled… buying cheap patents now and holding them might be a very good investment long term.” Keller would agree that the assets are quite cheap at the moment and could in time prove to be a good buy.

As true as it is that 101 is toxic and the Courts and Congress seem openly hostile to innovators generally and patent owners specifically doesn’t change the reality that there are still good patents that are full of claims that would not be negatively impacted by the Supreme Court’s decision in Alice, for example. Of course, the true value of a patent really cannot be identified unless there is infringement, or at the very least a well developed licensing regime that can set the value in the marketplace. But is it possible place a value patents that have not been and likely won’t be litigated? Yes. Is it easy? No. But if it were easy then everyone would be doing it. But only focusing on the valuation part of the equation is to look at the issue so closely that you miss the forest because you are focusing on the trees.

Of course, if the debt provider is doing their job properly the valuation of the assets is to provide a safety net in the event of default. The fact that certain patents are currently under assault has to weigh into the valuation proposition, but the debt provider is not in the business of providing money to acquire patents. The debt provider would rather never have the assets revert to them. They want regular payments to service the debt. Thus, who you work with matters on at least one level. “The story matters a lot, and management is super important,” Zur explained. “One should look at the management because it is extremely important how the company itself, not the assets, are going to succeed.” If management is bad that increases the risk and debt providers have to act accordingly.

As you learn more about what Zur and Fortress are doing it becomes clear that this is the way banks used to lend money, particularly with respect to providing mortgages. Today banks are not in the business of servicing mortgages, but rather are in the business of lending money and then flipping the note to an aggregator. That is why banks really don’t care any more whether the borrower has the ability to repay the loan —- they don’t plan on holding onto the loan for more than a few months, if that. What they care about is whether the borrower meets the criteria that will be demanded by the secondary market. It is a sad reality, but today banks don’t care whether you have never missed a payment in your entire life. If your ratios don’t fit into what the secondary market demands you will not get a mortgage.

Once upon a time, however, banks used to care about whether they were going to be repaid. As one friend of mine is fond of saying, in the past one of the most important relationships you could have was with your local banker. While we have clearly gotten away from that with respect to banks, Zur and Fortress are bringing that model back to life with respect to securing loans based on patents, specifically those assets that will not be put at risk.

Over and over again the discussion returned to whether and how much it is appropriate to consider whether the party being financed is a non-practicing entity or patent troll. “The issue is whether a non-practicing entity, because they are vilified, is a good investment,” Keller explained. He did go on to agree, however, that you could lend to non-practicing entities if you are going to get paid back on the loan payment secured with patents as the asset.

As the conversation wound down with respect to the divergent business models being discussed, Sener asked the panel whether they prefer to fund litigation costs or if they prefer to work with a firm that will take on the case on a full contingency fee. Not surprisingly, the divergent philosophies of Zur and Keller again surfaced. “We prefer to have the lawyers have skin in the game,” Keller explained, “but we will fund costs… we are very flexible assuming the asset value is there…” On the other side of the aisle Zur explained: “The investment thesis is different between a debt provider and an equity provider… I truly don’t see [having skin in the game] as an advantage because the hybrid approach always seems to be more expensive, the hours seem to catch up with me in addition to the backend… we have had one or more cases where there was no skin in the game by the law firm.” Keller would go on to recognize that “by giving up the points the lawyers will make more money and I want them to make more money.” Again, not that any philosophy is wrong or even better, but there are two decidedly different approaches to financing.